Fed Credibility Shot to Pieces
Any person who has ever interacted with dogs on a regular basis knows that you need to establish that you are the leader of the pack and that it (the dog) needs to follow you. Failing this, you will lose control, with varying destructive consequences (depending on the dog, of course).
Back at the beginning of September, I praised Ben Bernanke’s performance in keeping the markets off-balance. A casual examination of the economic fundamentals would have revealed that the Fed would have no choice, absolutely none, but to cut rates due to the housing bust. But Maestro Bernanke did a masterful job in that a significant segment of the markets were anticipating rate hikes (!?!), as evidenced by the spike in Treasury yields during early summer.
To have much of the market zigging right when the Fed’s inevitable path was a rate-cutting left was an invaluable aid to the Fed. It gave Bernanke the ability to influence market behavior without lifting his finger (or rates). It seemed obvious to me that this ability was so valuable — preserving the Fed’s jawboning ability to keep the markets from overloading on the rate-cut side and the inflationary pressures that would bring — I suggested that Bernanke may not cut rates at the September meeting and, like an owner with his dog, once and for all, establish his position as leader of the pack. Of course, the markets would have sold off. There may have been some panic and stories about the Dow on the front page of the Average-City Tribune. You would have had “experts” wondering on TV if Christmas would come this year and if the consumer was dead. It would have been a bad scene, no doubt.
But the alternative looked potentially worse. If the initial rate cuts failed to stabilize the markets (and the economy), the Fed would face a worst-case scenario: a deflationary spiral on Main Street, an entrenched inflationary trend on Wall Street, incomprehensible amounts of debt in both arenas and a dangerously weakened currency that promised to exacerbate the problems. But perhaps the worst outcome would be a growing realization that the Fed now faced the dreaded “pushing on a string” situation — no longer able to direct the economy where it needed to go.
Against that possible backdrop, holding the line on rates in September seemed a viable option. There would have been pain but no one would ever again doubt Bernanke’s inflation credentials without pause — they would have lost too much money the first time. In a venue where animal spirits reign, Bernanke would have established that he was top dog. After all, if the Fed is to direct the economy out of its current tight spot, it cannot lead from the back of the pack.
Of course, that is not what happened. The Fed cut more than expected and now we face markets behaving as petulant brats who refuse to believe the parents’ toothless threats. In life, timing is everything; sometimes, you only get one shot to get it right. If Helicopter Ben attempts to establish control at this point, the pain will be even greater. A huge market sell-off in the middle of an expected weak holiday retail season combined with tangibly high inflation amid increasing chatter of recession would deal a huge blow to investor and consumer psychology. The Fed’s beloved “expectations” (inflation or otherwise) would be in danger of becoming “unanchored” (unhinged may be more accurate). The Fed must step very carefully; I believe we may be perilously close to the oft-referenced “black swan” event.
The nature of Taleb’s black swan hypothesis is that it is not easily forecasted. That said, a possible catalyst could be the tenuous state of the US dollar (placed in this state, of course, by the Fed), fast approaching a flashpoint. Most market players allow ideology to cloud their view of the geopolitical environment which provides the context for all economic activity. Therefore, they may choose to ignore the ramblings of Hugo Chavez coming out of the weekend’s OPEC meeting. This would be a mistake.
Wall Street’s inability to think in non-linear concepts or to integrate non-economic factors into the financial markets is on full display here. The day after two countries openly challenged the US position in this world, gold is selling off. The significance of Chavez’s challenge to the US must not be understated. If the US dollar were to fall from it’s global reserve status, the American way of life would be over. Keep in mind that when Hugo Chavez calls George W. Bush “el diablo”, that I agree with Chavez. I am politically progressive-oriented and in general, sympathetic towards some of Chavez’ viewpoints. That said, if Chavez or anyone else came close to “ending the US dollar empire”, George W. Bush (or any other President) must prevent that from happening at any cost, including war, and I, even as a card-carrying Bush hater, WOULD WHOLEHEARTEDLY SUPPORT BUSH’S ACTIONS.
If I am right, this is a very dangerous time in the world. For more color, review this Barron’s cover article earlier in the year with Niall Ferguson. Financial markets tend to have tunnel vision. If you can’t put a dollar sign on it, Wall Street can’t see it. Ironically, in this case, it is the dollar sign itself that is the problem yet Wall Street pays no heed. In this environment, the concept of bonds as a safe haven is comical.
Personally, I think gold is one of the most useless investment classes in existence. It doesn’t matter what I think. Gold’s role as a store of value is established over thousands of years and among billions of humans. The fact that it is selling off should not dissuade you from the dangers ahead.
From an investment standpoint, I stand by my hard assets call. Base metals are selling off due to recession fears. If the US doesn’t start another war, base metals are a good place to be but I’d like to wait until they pull back a little bit more. Energy is good no matter what. Agriculture may emerge as the next major theme in the next year or two. And by all means, pick your spots to get out of the US dollar.
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